Will Cyprus Force Draghi to Finally Cut Rates?

Cyprus's troubles offer Mario Draghi an "excellent justification" to cut interest rates further at Thursday's European Central Bank meeting, according to a research note by Dutch bank ING.

"Since the beginning of the year, financial market participants have frequently speculated on a possible ECB rate cut. Up to now, the ECB has resisted the temptation," wrote Carsten Brzeski, a senior economist at ING based in Brussels.

"However, the changes in the macro environment since the last meeting and the aftermath of the crisis in Cyprus and its possible long-term impact on all euro zone banks could provide the ECB with an excellent justification for cutting rates at this week's meeting."

Most economists polled by Reuters expect the ECB to keep rates unchanged deep into next year.

Cyprus agreed a 10-billion euro ($13-billion) bailout from international lenders that include the ECB, the European Commission, and the International Monetary Fund. However, the tough terms of the loan have reignited anti-austerity anger, with investors set to take sharp losses on bank deposits.

Brzeski added that disappointing euro zone confidence indicators, coupled with lower inflation risks, also offered reasons for a rate cut. The ECB has held base rates at a record-low of 0.75 percent since July 2012, when they were cut from 1 percent.

"Confidence indicators disappointed in March, not only suggesting that the euro zone economy has stayed in recession in the first quarter but also that any recovery in the coming months will – at best – remain subdued. While the subdued recovery in itself will probably not be a surprise for the ECB, the fact that confidence took a severe hit in March should give new food for thought," he said.

Inflation fell to an average of 1.7 percent in the euro zone in March, according to a first estimate from Eurostat, the EU's statistical agency. The number was in line with expectations, and was down slightly from February's 1.8 percent rate.

"The ECB is presiding over a sharp economic downturn in the euro zone which shows no signs of abating and, in some areas, notably unemployment, is deepening," Nicholas Spiro of Spiro Sovereign Strategy, said in a note on Wednesday.

"The growing disconnect between financial conditions and the real economy is undermining the credibility of the ECB's policies at a time when inflation (particularly in the core of the bloc) has fallen markedly."

Spiro said that ECB President Mario Draghi will be "in the hot seat" at the press conference after the rates meeting, and could face some of his toughest questions yet.

"Having been intimately involved in the Cypriot bank bail-in, Mr Draghi, who has been one of the strongest advocates of a banking union to help shore up the ill-managed euro zone, must now explain how the harsh treatment meted out to depositors in Cyprus squares with the rationale underpinning a banking union," he warned.

Despite concerns about systemic risk to creditors in other countries, particularly Spain, Brzeski predicted the ECB will ultimately opt to keep rates on hold at Thursday's meeting.

"When assessing possible policy options to stimulate the economy, the ECB faces a new dilemma: choosing a rather ineffective but politically acceptable rate cut or an effective but politically controversial lending bazooka… In our view, the ECB will again resist the temptation and keep rates on hold on Thursday," he said.